Bonds can no longer be expected to be major contributors of return in your portfolio
Month after month, the Investment Funds Institute releases their monthly sales statistics, and each month, without fail, fixed income funds continue to see big inflows of new money while equity funds see net outflows. As of September 30, bond funds saw $15 billion of new money while investors pulled more than $10 billion from equity funds.
Given the current fixed income environment, this trend causes us great concern. We’re not the only ones either. A few months ago we sat down with Tom Bradley of Steadyhand Funds and he said that, “bonds used to be thought of a risk free return. But now, they are really return free risk.” He is not wrong. There is no conceivable way that the returns that bond investors have experienced for the past 30 years can be repeated and at some point in the future, bond investors may experience something most have yet to experience – a bear market in fixed income.
Let’s take a look at why we believe this to be the case. As you know, the price of a bond moves in the opposite direction to interest rates. Interest rates have been on the decline since 1982 when the ten-year Government of Canada Bond yielded nearly 16%. Today it is yielding around 1.8%. According to TD Asset Management, an investor in the Canada 10-year bond would have realized an annualized return of 10.4% between 1982 and 2012.
With yields, they can only go to 0%, since it is very unlikely that any rational investor would pay to invest in a bond under normal conditions. Considering that premise, the upside in bonds is very limited from where we sit today. For example, if interest rates were to move down to 0%, the best an investor can expect to earn in capital gains would be approximately 12%.
On the flip side, if rates move higher, bond investors can expect to realize a loss. For example, if yields move up to a more realistic 3%, then the loss an investor would experience is likely to be in the neighborhood of 8% or so. Should they move to 4%, the loss will be expected to be in the 15% range.
Looking at the near term outlook, central banks around the globe have committed to keeping interest rates low for the foreseeable future. Bank of Canada governor Mark Carney wants to move rates higher, but with many economic headwinds and the potential impact such a move would have on the Canadian dollar, his hands are effectively tied. This means that for at least the next few quarters, we don’t expect any significant movement in interest rates. Considering this, the best return one can expect from your fixed income investments is the underlying yield, less any fees. Looking at the DEX Universe Bond Index, which is a well known bond benchmark, the current yield is 3.6%.
Despite these low return expectations, we still believe that bonds should be a cornerstone of your portfolio. Our rationale is that when used in part of a well diversified portfolio, bonds can help make it more stable over the long term. Historically bonds move in the opposite direction to equities. In a portfolio this is important because when equity markets drop, bonds tend to be positive and reducing the losses for investors.
When looking at bond funds for your portfolio, there are a few characteristics which you we believe you should look for. They include:
- Low Fees – With bond yields expected to remain low for some time and relatively low expected returns, you will want to reduce the impact of costs, keeping more money in your portfolio.
- Active Management – With an active fund, the manager can do things such as increase the yield, shorten the duration and take advantage of other opportunities as they arise. They may also be able to invest in other strategies such as high yield, derivatives and currency, which can not only provide additional return, but also help protect you against major drops in value.
- Higher Yields – With yields expected to be the main driver of return for the near term, you will want to maximize them. As well, a higher yield can provide a better buffer against rising interest rates than lower yields.
- Lower Duration – The shorter the duration of a bond, the less it is affected by movements in interest rates. Given that rates will eventually be moving higher, you will want to shorten duration to help preserve capital.
- Global Bonds – Global bonds trade off of a different set of economic factors than Canadian bonds. By bringing some exposure into your portfolio, you can provide an extra layer of diversification than what you can get with only investing in Canadian bonds.
Bottom Line – Bonds have been and should continue to be an integral part of your portfolio. They can provide a tremendous safe haven in periods of uncertainty, and can help preserve the value of your portfolio when equity markets drop. Going forward, we cannot assume that bonds will continue to be a significant contributor to your overall return. They will NOT! Instead, look at them as a great shock absorber, making your investment ride smoother.